Multi-Strategy Hedge Funds: Formation, Benefits, and Drawbacks

The economy has experienced a lot of upheaval over the past several years. The challenging market conditions have in effect produced in investors a conditioned response, a desire to remain ‘safe’ as it were, in a volatile economic environment. This is where multi-strategy hedge funds come in. Investors are attracted to the funds’ ability to deliver strong, consistent, and positive returns as well as the relatively low volatility that they offer, due in part to their characteristic flexibility which allows them to allocate across asset classes and strategies.

So what exactly are multi-strategy hedge funds and how do they work?

In layman’s terms, multi-strategy hedge funds are hedge funds which engage in a number of different investment strategies in the same pool of assets. Some of them can be as broad as having eight to ten strategies under their belt while others may have only two or three. Among the strategies employed by a multi-strategy fund include, but are not limited to, statistical arbitrage and merger arbitrage, convertible bond arbitrage, and equity long/short. The diversification benefits help to smooth returns, reduce volatility, and decrease asset-class and single-strategy risks.

This diversity and flexibility is aimed towards achieving the investment objective of delivering consistently positive returns while remaining as close to impervious as possible to outside conditions such as the directional movement in equity, interest rate or currency markets. This lessens single-strategy and asset-class risks, smoothes returns and reduces volatility and is part of the reason why the risk profile of multi-strategy hedge funds, in general, is considerably lower than equity market risk.

The importance of an investment portfolio’s diversity has been proven time and again over the years. The risk of the overall investment programme is reduced when shifting risk to more than one fund or strategy. Hedge fund managers also benefit because they are more able to utilize their varied skill sets and are positioned to better capitalize on opportunities that present themselves. Multi-strategy funds have the ability to allocate funds in a certain strategy in response to market movements and trends, allowing them to more easily make the most of favourable market conditions.

Eric Starr of Starr Capital Management has pointed out that single-strategy funds are “limited in the scope of their investment opportunities. When the inefficiencies in a specific expertise of a single-strategy fund wave, managers may reduce exposure by shifting into cash or remaining invested in sub-optimal opportunities.” In comparison, multi-strategy funds are able to “allocate capital away from less-attractive strategies to those that offer superior opportunities.” Starr added that “multi-strategy funds can offer investors considerable capacity as investor capital is allocated across several strategies.”

Due to its complicated nature, multi-strategy managers cannot be your typical run of the mill managers. Mediocre skills will not make the cut when it comes to managing the various strategies utilized by multi-strategy hedge funds. Emma Cusworth in her article for Hedge Fund Reviews in 2012, pointed out that the “complexity of the multi-strategy model means manager selection is a challenge.” Starr noted that “successful multi-strategy managers have developed ‘best of breed’ investment programmes in each of his strategies.” Thus, “[f]lexibility, capacity, and high risk-adjusted returns are some of the benefits of multi-strategy funds.”

There aren’t a lot of multi-strategy hedge funds in existence though, since establishing such a fund is difficult enough let alone its upkeep and maintenance. It takes a particular type of person with a specific skill set in order to be successful in such a fund and to found it even doubly so. But how did multi-strategy funds come to be? Cuswoth explained that “[m]any [multi-strategy funds] were born from successful hedge funds that expanded beyond their core strategies as their business grew and attracted more assets. Furthermore, being able to allocate assets across a range of strategies and retain the talent required for doing so requires significant scale.”

“The extensive growth in hedge funds resulted from the migration of talent and entrepreneurial investment professionals from large asset management firms to independent, nimble, specialised firms. The skill sets developed at the large, traditional asset management companies could be better put to use in specialised strategies that removed traditional market risk and provided investors with absolute returns,” wrote Starr. “Many of these specialists built successful hedge fund businesses centered on a core competency. As these specialist managers demonstrated the value of their strategy by generating high, risk-adjusted returns, the demand for their expertise grew. Managers were faced with a choice: close their funds to new investors, or find new ways to increase fund capacity.” He explained that “[t]his search for capacity resulted in the launch of new funds with different strategies. In some cases, managers developed their own expertise in a new discipline, while others chose to add talented professionals to the existing staff, introducing additional expertise to the mix. The increased strategy scope of hedge fund managers gave rise to the multi-strategy hedge fund category.”

Cusworth reported that, according to Grace Gu, a hedge fund manager at BlackRock, multi-strategy hedge funds “requires huge investment to maintain the necessary deep bench of talent for successful multi-strategy funds. Having scale therefore means a better ability to afford that talent…A better brand name will also attract better talent and there is the issue of critical mass; smart people attract smart people.” And to be successful at this type of fund, intelligence is not a bonus but a must.

According to Cusworth, the head of liquid alternatives at Aon Hewitt, Guy Saintfiet, stated that “[i]nvestors need managers who can add value by trading, especially when markets are not behaving rationally. Therefore being invested in a trading-oriented strategy makes sense and that is what multi-strategy funds offer.” Cusworth added that “[e]ffective asset allocation, or shifting assets around the various strategies within a fund to take advantage of market moves, sits at the heart of a multi-strategy fund’s value proposition. As such it is something at which a fund needs to demonstrate considerable skill.” Thus, the need and demand for smart and talented managers with the skill set and savvy to properly handle asset allocation.

“Mark van der Zwan, a portfolio manager at $26 billion Morgan Stanley Alternative Investment Partners (MSAIP), says this capital rotation ability should be a key consideration for investors when selecting a multi-strategy manager,” Cusworth wrote. According to van der Zwan: “It is critical that a manager can demonstrate an ability to generate alpha through active rotation of capital above and beyond their single-strategy alternatives, especially given the use of multi-strategy funds to access opportunities that are susceptible to cyclicality.” And with the market outlook continuing to be uncertain, “driven in part by political and monetary interventions that make trading conditions difficult for all participants,” Cusworth concluded that “the attraction of a strong asset allocation skill will likely remain paramount.”

Despite the strong returns and relatively low volatility of multi-strategy hedge funds, as well as the high calibre of talent it attracts, it is not perfect. A drawback to this type of investing strategy is that it will rarely, if ever, be the highest performing hedge fund over a short time period as the very thing that gives it the ability to weather the financial storms caused by changes in market forces, its flexibility and diversity, also dilutes its ability to garner high returns.

“Seldom will multi-strategy funds be the best performing category of hedge funds over a short-term time horizon. Diversification of strategies will water down the returns of a single strategy during a very “hot” period,” wrote Starr. “An example might be if convertible bond arbitrage performs exceptionally well during a 12-month period, while equity long/short delivers acceptable returns. Convertible bond arbitrage managers will outperform multi-strategy managers who engage in both disciplines.” He then pointed out that “[d]uring a longer time period, when convertible-bond arbitrage falls out of favour while equity long/short performs very well, multi-strategy managers may outperform convertible bond funds but underperform equity long/short managers.”

“In the long term, however, the consistency and performance of multi-strategy funds should prove their worth, delivering low volatility, and high risk-adjusted returns both in absolute and relative terms,” wrote Starr. “Multi-strategy funds can offer investors access to a variety of strategies, provide considerable capacity and enhance the risk-adjusted returns of a diversified or concentrated investment portfolio.” In other words, the relative risks involved in such an investments is far outstripped by the benefits to be wrought in investing in multi-strategy funds.